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Clearing Up

Today was another ugly day, capping off an ugly week for stocks.  Thus far, everything we see is still constructive toward the development of a meaningful bottom.  Because you asked - we are purposely sending out more frequent but brief updates for our clients and interested parties given the current volatility in the markets.  When things settle down and a new trend develops, you’ll hear from us less.  Beginning with the 4thquarter, this Red Sky Report will become more event driven in timing, content and frequency breaking from nearly nine years of delivering on Mondays.   I won’t do Twitter on principle because I won’t be a part of the A.D.D. society.   But we’re happy to adapt to the interests of our clients as driven by the kind suggestions of our advisory board.  Please excuse my wild speculations with this update.


Mid to Late Stage of the Economic Cycle


After a week of pouring through winners (smaller losers) and losers (bigger losers) among the various investment asset classes, sectors, countries and style specific funds, the market situation today is becoming more clear as it relates to the economy, risks and opportunities.  Let me address what we see in that order. 


First, the economy; Based on the continued show of healthy economic reports in the last several weeks and months and the Fed’s recent commentary suggesting rate hikes are still likely, we must all accept the high probability that we are in a mid to late stage of the larger economic cycle.  There are two take-aways from that statement.  The first is that we are a long way off from a recession and the financial markets rarely (if ever) experience sustained bear markets without the presence or high probability of a recession in the foreseeable future.  There is no recession in the foreseeable future according to most recent reports and longer-term trends (housing, employment, consumer confidence, low rates, cheap gas, rising US dollar, etc).   Smart investors will therefore continue to look at the recent mini-crash as a stiff and painful correction until further notice.  Good friend and smart fella, Paul Schatz of Heritage Capital in Connecticut, offered up these charts as possible anecdotes for the current market pattern compared to other similar “crashes” in the past include the mother of all (1987).  He’s doing a segment on CNBC on Wednesday on the closing bell on these crash patterns.  The patterns are pretty clear following exhaustive events like we saw in the week of August 24th.   This is not a guarantee but a strong indication that history is now on our side.  The charts also suggest that we still need to see that messy complex bottom over the course of the next two months with several tests of the lows (intraday) before we can really get up and go again. 







Second, we can take away the real possibility that the economy is actually on the verge of making the transition FROM the Mid-stage TO the Late-stages of the economic cycle.  Now this is where we will find new risks and very exciting new opportunities for investors so pay attention.  Evidence surround the shift from mid stage to late stage or from Stage III to Stage IV among business cycle gurus is coming from recent price trends among different asset classes as well as the fact that this transition typically and historically occurs at or near the first rate hikes by Central Bankers (October?).  So what should we be looking for?  Take a look at the graphic below from the business cycle guru Martin Pring.  From our seat, we believe we are not yet in the Stage IV (late stage) environment shown on the graphic but rather right on the line between Stage III and Stage IV.  Once the Fed raises rates, we should land firmly in Stage IV – but it hasn’t happened yet.




So what does all this mean in relation to future market trends, risks and opportunities?   Well for one, it gives us some grounded hope for the expectation that the bull market is not over yet and we might very easily see all time new highs in the coming quarters.  As I said, do not give up on this bull yet!  Stocks will also continue to be one of the best performing asset classes really until much later in the cycle when inflation and the “expense” of a higher interest rate environment begin to cut into consumer’s purchasing power.  We’re talking about an environment that has seen 3-4 rate hikes by the Federal Reserve from where we are today, potentially several quarters away.  But not all stocks will do well in this coming late stage cycle.  In fact, we’ll likely see a smaller and smaller group stocks carry the benchmark’s higher while it’s quite possible that many companies which are heavily in debt, over priced and have low free cash flow will suffer as borrowing costs rise.  Earnings for these companies will fall, as will their stock prices.  These are the classic “interest sensitive” groups like financials and utilities and they will be riskier holdings.


Meanwhile, other companies in the growth segment that might even benefit from a higher inflationary environment are likely to lead.  These are likely to be in the Technology, Healthcare, Industrials, Materials, Real Estate and Consumer Discretionary sectors.  What you might also have noticed in the graphic above is that Inflation Sensitive groups begin a new period of strength at the expense of bonds, which should be sold according to cycle theory. 


So here’s the exciting opportunity I spoke of.  Commodities and the energy complex could see an intermediate to long-term bottom soon.  Both have been absolutely hammered by the markets in recent years and thrown out for dead.  Anything that hurts if you dropped it on your foot (metals, a barrel of oil, gold, mining, cement and other basic materials) is down 60-90% in the last 5 years trading at 10 and 12 year lows in price.  In classic fashion, S&P just lowered their rating on Freeport-Mcmoran - FCX (Mining company) to a sell.  Really?  The stock is down 80% and threatening to make a new 12 year low in price.  Contrarians are scribbling FCX, FCX, FCX all over their desks.


I believe there is a developing opportunity to buy back into the commodities sector (which includes energy) very nearly after the Fed’s first rate hike. Their day is coming and we will be ready to deploy some of the pile of cash we have accumulated since June, now nearly 50%.  Each of our equity and blended asset sets of strategies has buckets available to own commodities as they did in the early 2000s.  At full exposure, we will have 20-25% in commodities if conditions warrant. 


Once again, we continue to view this mini-crash market meltdown as an opportunity to add some sideline cash to investments (Calling All Cars!) but be very patient in deploying that cash over the next 60 days.  As promised, I did so today for my kids 529 plans for 50% of my annual contribution.  Did you?  We also look at this broad market decline as an indication of a cycle change to possible late cycle inflationary leadership including some very attractive opportunities in the energy and commodities sectors.


That’s it for today – I hope that helps clear things up a bit and gives you some peace over the long labor day weekend.  Our offices will be closed on Monday in observance of the holiday. 




Sam Jones